Household debt: the slowly developing crisis of capitalism

This week there is much debate on whether the Bank of England or the US Federal Reserve should raise interest rates from their current rock-bottom level. Behind this lies an important debate on the future of our economic system. A crisis, arising from high levels of household debt, is in the making.

Let's set this in some sort of context. In the 1950s and 1960s levels of household borrowing (that is mortgages, car loans, consumer debt and such) were strictly managed, in a system designed to ensure financial stability as part of the global Bretton Woods system of managed exchange rates. This era is often viewed as something of a golden age by people on the left, as there was steady growth across all levels of income, and high levels of social mobility. There is a tendency to attribute this to the Keynesian consensus, of which the Bretton Woods system was a part. In fact it also had a lot to do with the explosion of consumer goods industries which set in motion a virtuous circle of job creation and increased household consumption.

By the 1970s this system had broken down. The Bretton Woods system collapsed as the United States sought to finance the Vietnam war without raising taxes. We entered the world of floating exchange rates, which allowed much greater freedom for both public and private sectors to borrow money. Middle East tensions saw a spectacular rise in oil prices, which disrupted developed world industries. The consumer boom started to reach saturation, and growing productivity halted the job creation machine. Much heavy industry, such as coal-mining, and steel production, became obsolete, along with other job-rich industries like textiles. Keynesian economic management simply led to inflation while unemployment continued to rise.

Enter the neoliberal era, starting in the 1980s. Governments embraced the freer financial system. Consumer demand was now sustained by growing levels of household borrowing. Alongside this came an expansion of world trade. Developed countries bought growing amounts of goods from developing economies in Asia; the first wave were the "Asian Tigers", especially South Korea and Taiwan; these were followed by the giants of China and India. This expanded trade reduced prices for consumer goods, and allowed a period of steady, if somewhat uneven, income growth in the developed economies. Slowly the developed economies reshaped themselves to a combination of highly productive high technology jobs, and a mass of low productivity service jobs, especially in healthcare. But the uneven nature of income growth, sustained by household borrowing was creating strains by the mid 2000s. In Britain household debt had increased from about 50% of national income in 1980 to 160% in 2007.

Then the great financial crisis struck in 2007, reaching its climax in 2009. This was only indirectly linked to high levels of household debt. The crisis mostly arose because the finance industry was allowed to grow in a very unstable way. This gave the illusion of growth, especially in Britain, in the years before 2007, only for the awful truth to be revealed when the government had to bail the system out. By and large, that source of instability has been fixed. But meanwhile globalisation as a source of growth for the developed world has run its course, while increasing productivity has become like running up a down escalator. Improvements in one area of the economy are most likely undermined by the creation of low productivity jobs in another, in a process economists call the Baumol effect. We are stuck in an era of low economic growth in the developed world.

Which is why some people are starting to worry about levels of household debt. Since the crisis household debt in Britain has been bumping along at about 140% of income, and it has been trending up in the last two years. But people's capacity to repay debt is weakening. Back in the 1980s it was assumed that rising incomes would make debt more affordable. This is plainly not the case.

A further risk factor is that central bank interest rates are rock bottom. These interest rates are not the same as what is charged to real people and businesses (something we learned during the crisis, when the central bank cut interest rates, but most consumer interest rates went up). But it doesn't look as if the interest rates people pay are going to get any lower, and so debt become more affordable. In the past central bankers could help alleviate crises by cutting interest rates, but now they have run out of road.

A third risk factor is asset prices: the price of property, shares and bonds. All three look high by objective measures, and so could fall. The process by which asset prices are set is complex and mysterious. But if assets are sold to unwind debt, then prices are liable to tumble.

Stagnant incomes; interest rates that can't be cut; asset prices that look too high. This is a toxic brew. Some people hope that by raising interest rates gradually, we can slowly normalise the financial system, with overall levels of debt stabilising or even falling. Others fear that any rise in central bank rates will trigger a downward spiral.

But we need to understand that wider perspective. The neoliberal system has become unsustainable, and developed countries (especially the British and American ones that embraced it so wholeheartedly) need some fresh thinking.

One point should be clear, but still remains under-appreciated. Levels of private debt need to fall, and the safest route to doing so, without a disastrous collapse in demand, is for public debt to replace it. In other words we should not be so worried about budget deficits and national debt. However government spending needs to focused on things that will support the transition to something more stable, rather than just propping up structures that will be unsustainable in the long run. Ultimately national debt can be unsustainable too (though just when that point is reached is very much a matter of context; Japan has public debt of 200% of income without much sign of trouble). This is a national debate we badly need to have.

A second point also seems quite clear to me: asset prices must fall. This includes property, shares and bonds. This is required to correct some of the toxic inequalities of wealth. That will clearly create hardships and problems, but the government must stand ready to tackle these. Putting off the evil day will not help. That is why I think that central banks need to start the process of raising interest rates.

And a third point is that we need some serious policy ideas on how to tackle the issue of low pay for low-productivity jobs. It is no use hoping that productivity is going to resume the steady growth it saw in the later 20th Century. The forces that drove that - automation of manufacturing, and globalisation - are played out. In my view that means a much bigger role for the state in supporting society - but not by an unaccountable and out of touch central government.

These are radical changes. History teaches us that such radical change only comes from crises. There will be a new economic crisis. The only question is when, and whether our leaders will be intellectually prepared to manage its aftermath.

We need to understand why household debt, or, more generally private debt is the problem it is.

The conventional wisdom is that having lower interest rates will accelerate economic activity and higher rates will slow it. That’s not quite right. It’s the process of lowering them, and/or deregulatind lending, that stimulates demand. So in mathematical terms it is the rate of change of the increase in credit, or the first derivative, which determines whether economic policy is reflationary or contractionary.

Consequently, lowering interest rates appears to produce a stimulation but the effect wears off and another reduction is then necessary. After a time, we end up with interest rates close to zero, fretting about price bubbles bursting in the property market and wondering what to do next.

Just like we are now!

Yes there will be a crisis. It doesn’t really matter if our leaders themselves aren’t intellectually prepared. They just need to choose to listen to the right people if they aren’t sure themselves. Whether or not they will remains to be seen. My guess is that they’ll initially get it all wrong but then they’ll be forced kicking and screaming to do the right thing.

Well that certainly seems to describe what is happening. One wonders whether it is the use of short-term techniques to manage the business cycle are being used to combat secular trends that derived from demographics, trade patterns and technology. Fiscal stimulus could end up the same way (Japan would bear that experience out). Except, I think, if the fiscal stimulus is applied the right way (it wasn’t in Japan). The quality is more important than the quantity. That is the main weakness of monetary stimulus: it is impossible to direct it in the most constructive way for the medium and long term economic health. At least with fiscal stimulus you have that chance.

The idea of the importance of the acceleration in the rate of increase of credit comes from Steve Keen. Steve complains that the mainstream tends to ignore all this in their models. I find this hard to believe. It’s easy enough to understand. If we save for a expensive purchase, say a car, on an individual level, we initially create a deflationary effect by saving. Later we create an economic stimulus when we do buy the car.

If we borrow to buy the car the stimulus come first and the deflationary effect of having to service the loan repayments comes later. Both processes are economically neutral providing the random nature of everyone’s savings and borrowings cancel themselves out. Is that all the mainstream assume?

But, if the Govt eases lending regulations and/or the central bank reduces interest rates then there will be a tendency for that not to happen. Everyone does the same thing at the same time. So initially we have a boom when all the borrowing and spending is taking place but later the deflationary effect sets in as everyone has to make their repayments.

So it would seem to me that constantly fiddling around with interest rates is a poor way to regulate the economy. We should decide what we’d like them to be and try to keep them at that. They may need to be changed from time to time to keep them in line with what other countries are doing but that’s about it